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A/E Firm Contracts and Risk: Important Observations
July 29, 2020
Every architecture and engineering (A/E) firm understands this about the work they do: the risk of financial loss, damaged relationships, and client departures begins on the day you sign a contract. That’s not “glass half empty” thinking; it’s just a fact. And while firms today are putting more time, effort, and capital into micro-analyzing contracts than ever before, it doesn’t seem to be resulting in a significant decrease in the number of issues that arise or the professional liability insurance claims that are filed.
Fortunately, we’ve found that there are ways to minimize risk beyond the terms that are in a contract. We explain below.
Critical Questions About Risk
In our experience, A/E firm principals tend to ask themselves two questions about risk: “Based on the contract, what is the risk of us losing money on this project?” And, “What are the chances that because of the way the contract is slanted we get sued?”
These are high-level, strategic considerations, but what’s a surprise to many firms is that the answer to these questions really comes down to how well project managers (PMs) execute on the contracts and also to firms not setting them up to fail by promising too much to clients. Consequently, the firms that do well are the ones that have a cohesive and consistent policy for managing contracts.
How to Decrease The Chance of Losing Money on a Project
To principals who ask us about how they can keep from losing money on projects—or maybe stated more positively, how they can increase their odds of making money on projects—we recommend using value-based contracts, also called lump sum or unit price contracts. These contracts state what a firm will be paid for the deliverables listed in the document. This type of project is easy to manage in a product like Factor A/E.
The other option is cost-based contracts. The downside of these contracts is that they require very precise tracking of costs, which becomes a huge bookkeeping and administrative burden for the firm. And that’s true regardless of which type of cost-based contract is used (cost plus, cost plus fixed fee, time and materials, etc.). Who worked on a project? What are their billable rates? What’s the agreed-to multiplier? You have to get all your ducks in a row and then report your time to the client in a format they accept, so they can ensure they aren’t getting billed for time that they didn’t approve. It’s a major hassle, and if you’re using QuickBooks, you’re out of luck since its job costing features really won’t support this approach.
Value-based projects are much easier for PMs to manage, including that they can be billed much more efficiently and effectively. A PM is going to be far more capable of saying when a deliverable (a set of drawings, a report, etc.) has been provided to the client than the accounting system is of reporting how much time it took. So, using a value-based approach sets up PMs (and by extension, the firm) for success.
Of course, firms tend to be concerned that they’ll lose money on value-based projects if it takes longer than expected to complete the work. But what we find is that lump sum projects are so much easier to manage that the risk of losing money is less. This is true because when a firm prepares to sign a value-based contract, careful, detailed scoping of the project is a natural consequence.
And those details help the PM manage the budget, since they know exactly what they are expected to do and not do. In fact, even if a client insists on a cost-based contract, we encourage PMs to approach the work with a value-based mindset and to have an internal mental budget that they are working toward.
"The firms that do well are the ones that have a cohesive and consistent policy for managing contracts."
How to Limit Your Professional Liability
Professional liability is the other side of the risk associated with contracts. And another painful truth that A/E firms understand is that virtually every project has “issues” of some kind. Poor decisions, inaccurate drawings… there are many things a client can point to as ways that the A/E firm has failed to meet their expectations.
From our perspective, the best defense against onerous contract terms and the lawsuits that can result from them is summed up in the saying, “An ounce of prevention is worth a pound of cure.” In A/E firms, that “ounce of prevention” is ensuring that you are really good at project management.
The truth is that neither A/E firms nor their clients want to spend money on lawyers. They’d like to sign the contract, throw it in a drawer, and never look at it again. The top reason clients pull the contract back out and go through it to review the terms is that they’ve been let down by their PM. Often this occurs because of unreasonable or unmanaged expectations. And now, the client is looking for compensation and the verbiage that says they’re entitled to it.
The firms we work with tell us that first the client stops paying its bills and then they attack the technical quality of the work that’s been produced. And, of course, no firm has ever produced a perfect set of drawings. What can prevent minor issues from becoming the focus of a major disagreement is a strong PM/client relationship that allows for corrections to be made on the fly rather than both parties immediately consulting their legal counsel.
One of the largest providers of professional liability insurance to the A/E industry did a study and found that just 10 percent of claims clearly came from technical errors. The other 90 percent were relationship-based. What’s more, just 2 percent of the claims came from contract terms. So, training PMs not only in how to manage projects but also how to manage clients is essential.
That said, firms point out that you do, of course, need to be careful about what you sign. The A/E industry is one where it has become shockingly prevalent for clients to present terms to the firms that do work for them rather than the other way around. And those terms often include things like consequential damages and unusually high standards of care that firms shouldn’t have to meet. Consequently, it’s our advice that while firms may need to sign the client’s contract in order to get the work, they should have their own contract ready as well—one that has provisions protecting their interests and that the client has to sign before they start working.
We also encourage firms to have ample professional liability insurance and to leverage the skills and expertise of the insurer. Insurers typically are also happy to “take the fall” for their clients. “We’d like to accept this term in your contract, Mr./Ms. client, but our professional liability insurer says we can’t. Sorry.” a savvy A/E firm will say!
But again, time and money spent on improving project management and supporting PMs with the right systems delivers much better results than more hours reviewing and tweaking contracts. Stuff happens on every job—it’s what happens next that matters.
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